Due diligence not a retrospective task for buyers

Australian Financial Review, Thursday 16th of November 2006

ENTERPRISE QUARTERLY

Alexandra Cain

It is important to think about whether you could do the same - or better - than the current owners, says Alexandra Cain. When assessing a business for sale, it is not about understanding what a business has achieved in the past but working out what it is capable of doing in the future.

Many assume a retrospective analysis of a company's operations is the most important part of a due diligence process, but experts advise that modelling the business's future potential for earnings should be the key concern when running the ruler over a small enterprise. "It's all about what you think you can achieve in the future with the business," says specialist small business accountancy and corporate finance house MHM partner Mark Watson.

"You need to think about whether in the future you can do the same thing or better with the business," he says. If you are buying a business in which much of the value is tied up in intangible assets, or the business depends to a large extent on the relationship of the owner with customers, - it's particularly important to be realistic about whether you can achieve the same level of earnings if the principal is no longer with the business.

Working out whether you can earn as much in the business as the previous owners starts with a revenue analysis.

"You need to determine the revenue stream and get a handle on gross profit, and work out if this is what you can achieve yourselves," Watson says. Key costs to check are those that will affect the level of retained earnings - including staff wages, the cost of leases or mortgages and the running of plant and equipment.

Watson says: "You can get to the bottom of a business without looking at every expense".

Another partner at MHM, Paul Holman, says: "It's important to look at the full span of costs - for example check whether mum and dad are being paid a full wage if it's a family business".

It's very important to remember that buying the equity in a business involves the purchase of assets - and liabilities. Although some expenses such as wages and leases have already been mentioned, it's also crucial to check the business's other liabilities. One of the most important areas of liability to assess is tax. GST, pay as you go (PAYG) and payroll tax are just some of the things a potential buyer needs to understand.

"The payment history of other statutory obligations, like compulsory superannuation contributions, gives a good feel for a company - the first thing a small business in trouble tends to hold back is super and PAYG," says Watson.

Aside from financial considerations, there are a range of legal considerations that need to be made before buying a small business. Chairwoman of the Institute of Chartered Accountants' small business group Sue Prestney advises small businesses to be particularly careful about legal protections for their brands.

"Lots of small businesses have nothing much except a brand - you have to be careful the brand has been trademarked in the right countries. "Similarly, lots of businesses rely on open relationships with suppliers - but in reality, if the current owner leaves, this relationship might be over. These sorts of things have to be formalised," Prestney says.

Checking that the terms of customer contracts and building leases remain the same if the business changes hands is also necessary for due diligence. The nature of the employment contracts into which the business has entered - including leave and redundancy entitlements - is another area that requires attention.

Aside from focusing on the business and its operations, it's also crucial to check the viability of the industry in which the business operates. "You need to find out why the current owner wants to sell the business," Prestney says.

Ensuring the information given by the vendor during due diligence is correct is another key concern.

Principal of Business Angels, Christine Kaine, which matches small business owners with potential buyers and investors, says it's possible to "go as far as verifying bank transactions" to ensure the financial information is accurate.

"People often feel they are asking too much [when asking for financial information] but a buyer must have access to it," Kaine says.

If there is not the possibility of doing a full due diligence process, it's advisable to seek warranties and indemnities from the vendor before going ahead with the sale.

However, accounting firm PricewaterhouseCoopers partner John Cannings, a lawyer by trade, warns that "any warranties are only as good as the person giving them".

Or, as the Romans used to say: Caveat emptor: let the buyer beware.

Be informed:

• Start by analysing all revenues, costs and profits.
• Check the viability of the industry in which the business operates.
• There are also a range of legal considerations that should be investigated. 'A small business in trouble tends to hold back super and PAYG.'

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